On Monday, the Federal Reserve released a report that identified three assets with funding risks: certain money market funds, some bond funds, and stablecoins. The latter sector, it said, "remains exposed to liquidity risks" and "vulnerable to runs."
That same day, Terra's UST stablecoin lost over 30% of its value during a bank run hastened by low liquidity on the network's primary lending protocol, Anchor. Two days later, the stablecoin has drifted even further from its peg, while Terra's native LUNA token has lost nearly all of its value. Similarly decentralized stablecoins, including Neutrino, FRAX, Celo Dollar, and sUSD, have found themselves below the $0.98 mark at some point this week as consumer confidence is being tested.
The natural question is: Is this the end for algorithmic stablecoins?
First-generation stablecoins from Tether and Circle maintain their value via assets in the bank. Every time someone purchases 1 USDT or USDC for a dollar, Tether or Circle takes that dollar and stores it so that holders can always redeem what they have. That's the idea, anyway. In reality, a variety of other "cash equivalents" and/or debt instruments may be backing the coins in circulation.
UST, like other algorithmic stablecoins (or "algos"), works differently. It maintains a peg to the U.S. dollar via its relationship to another crypto asset. In Terra's case, to mint 100 UST, you must burn (or take out of circulation) $100 worth of LUNA, which has a floating value. To mint $100 worth of LUNA, you must destroy 100 UST.
The intended mechanism here is clever. If the value of UST on the open market somehow starts to decline, you can still redeem it for the full value of LUNA. For example, if UST is trading at $0.95 each, you still get $1 worth of LUNA. The arbitrage opportunity theoretically keeps the price stable.
But that's been broken as LUNA isn't worth what it used to be either. By the time people could swap their UST for LUNA, the price had fallen further.
It's worth noting you can always redeem 1 $UST for $1 worth of $LUNA, even if $UST is worth <$1.
It's meant to be a stabilizing mechanism:
If $UST is trading at $0.99, arbitrageurs can buy it and redeem it for $1 of $LUNA.
— jonwu.eth (@jonwu_) May 9, 2022
"Honestly, I'm pretty skeptical that there's much of a future for algorithmic stablecoins," Justin Rice, VP of ecosystem for Stellar Development Foundation, told Decrypt. The payments-focused Stellar blockchain supports a number of stablecoins, including USDC.
"What we're seeing now, and not for the first time, is an optimistic balancing mechanism unraveling due to natural human responses to market conditions," he said.
As Rice alluded to, algorithmic stablecoins have lost their peg before, though never one as big as UST, which had a market cap of $18 billion.
Last month, Neutrino, an algorithmic stablecoin attached to the WAVES blockchain, lost its peg. Similar to Terra, it faced accusations that its tokenomics were a mere Ponzi scheme reliant on the belief that the network's native token would only keep going up in price over the long term. It's still trying to get back to parity with the dollar. And this weeks' crypto market troubles pushed back its progress.
Nik Kunkel, former head of backend services for Maker, which created the decentralized and overcollateralized DAI stablecoin, suggested that stablecoins don't fail because they're algorithmic—they fail because there's not enough backing them.
"Partially collateralized stablecoins have repeatedly failed over and over," Kunkel told Decrypt. "They cannot solve the fundamental problem of bank runs when the peg is under pressure."
Rohan Grey, a Willamette University law professor who helped draft legislation that would have regulated stablecoin issuers to get a banking charter, told Decrypt that this can happen when things aren't going well in the broader market. "[Algorithmic] stablecoins are even more dependent purely on theories of collateral pricing than intermediated stablecoins," which include centrally controlled Tether and USDC. "So in that respect I think it's far more vulnerable to pro cyclical market volatility."
Intermediated stablecoins, he said, "at least have an institutional governance entity with its own equity that could backstop in a crisis"—though he and Kunkel share the concern that they're at the whims of a central authority that could act dishonestly.
Centralized stablecoins have faced similar tests. Tether dealt with such a crisis in 2017, when its price moved to $0.91, according to CoinMarketCap. It survived, but took over three weeks to get back to $1. It's now the top stablecoin by market cap—and the third-ranked crypto asset behind Bitcoin and Ethereum.
UST can do the same thing, but not on its own. "It is challenging to have algorithmic stablecoins keep their peg when things go sideways," said Rice, "and you have to rely on outside intervention to set things right."
Terra creator Do Kwon and the Luna Foundation Guard have come to realize that they'll need outside intervention. In a Twitter thread Wednesday, Kwon said Terr is looking for "exogenous capital" in combination with implementing protocol changes to help it get back on track.
Crucially, he said the rebuilding process would involve using a collateralization mechanism. In other words, something will back Terra's value other than Terra.
Terra was already well down that road, having purchased over $3 billion worth of Bitcoin, Avalanche, LUNA, and UST to use as reserves in case of market turbulence. But with UST worth more than six times that at its peak last week, it wasn't enough collateral. The reserves have been all but emptied.
Celo co-founder Marek Olszewski tweeted that Terra's reserve system was the right move but that algos could be made "even more stable with an even more diverse basket of assets." Celo's algo is backed by CELO, BTC, ETH, fellow algorithmic stablecoin DAI, and carbon credit tokens. It too, however, dipped to a low of $0.96 today before spiking back up to $0.99.
According to Rice and Kunkel, there's no shortcut here for decentralized stablecoins, which want to eschew government currencies and have long searched for a way to do that without full collateralization.
Most importantly, the recent event shows just how critical it is to back these types of stablecoins with multiple assets. The move to partially back UST with BTC right before this event was thoughtful and no doubt helped prevent a larger de-peg.
— Marek | Celo 🇺🇦 (@marek_) May 10, 2022
While Rice said that stablecoin projects can maintain consumer confidence through fiat collateral and third-party attestations, Kunkel leaned into the transparency of public blockchain ledgers.
"An ideal stablecoin really needs to be both overcollateralized and decentralized," he said. "Overcollateralization to give users of the stablecoin confidence that it will retain its value. Decentralization so anyone can see the reserves on-chain in real-time and verify for themselves the protocol is solvent."
Terra users can see for themselves that the protocol isn't solvent. Now all they need is some confidence.